This is a blog about interacting systems and how they behave: systems thinking construed broadly. Financial markets and economics; politics; and occasionally physical systems are discussed, with an attempt at focusing on how the rules of the game determine the strategies of participants and the possible outcomes.

Tuesday, 14 April 2009

Systems thinking in the Crunch

Edmund Phelps has a very good article in the FT which harmonises with many of the preoccupations of this blog.

In countries operating a largely capitalist system, there does not appear to be a wide understanding among its actors and overseers of either its advantages or its hazards... Capitalism is not the “free market” or laisser faire – a system of zero government “plus the constable”. Capitalist systems function less well without state protection of investors, lenders and companies against monopoly, deception and fraud.

In order to understand a system, you need to understand its behaviour, and how changing the rules which constrain that behaviour constrain the dynamics. There is no more a 'right' set of rules for something as complicated as a market as a 'right' set for a mobile telephony or a ball game. Some rules produce more efficient or interesting behaviours: some suffer significant disadvantages.

In essence, capitalist systems are a mechanism by which economies may generate growth in knowledge – with much uncertainty in the process, owing to the incompleteness of knowledge.

Growth in infrastructure too: roads and factories and such like. The knowledge moreover is encapsulated in conventions, or rules of the system: a mobile phone is useless without a network of towers that it can communicate with. Capitalism attempts to solve a massive collection of coordination problems - and often (as with the worldwide phone system), it succeeds.

Well into the 20th century, scholars viewed economic advances as resulting from commercial innovations enabled by the discoveries of scientists – discoveries that come from outside the economy and out of the blue. Why then did capitalist economies benefit more than others? ... [Hayek] felt free to suppose that, thanks to the specialised insights each acquires, a manager or employee may one day “imagine” a commercial departure – one that could not be inferred or envisioned by people outside the individual’s line of work. Then he portrays a well-functioning capitalist system as a broad-based, bottom-up organism that gives diverse new ideas opportunities to compete for development and, with luck, adoption in the marketplace. That “discovery procedure” makes it far more innovative than the top-down systems of socialism or corporatism.

This is of course an important (and well understood) point. However most wealth, in the general sense, is created not by true blue skies innovation, but by inside-the-system thinking. 3G phones are possible because we already have second generation infrastructure: ABS only makes sense under some assumptions about road surfaces and driving conditions and so on. Thus the role of capitalism is not just to act as an evolutionary force allowing great new ideas to generate wealth. It must also provide infrastructure - pensions, banking, law, transport, health care and the rest - within which incremental development can take place. There are many non-optimal local maxima here: the US healthcare system is a good example. Phelps makes this point less forcefully:

Well-functioning capitalist economies, with their high propensity to innovate, could arise only when serviceable institutions were in place.

Note however that there is an inherent volatility in capitalism.

From the outset, the biggest downside was that creative ventures caused uncertainty not only for the entrepreneurs themselves but also for everyone else in the global economy. Swings in venture activity created a fluctuating economic environment.

You can have slow wealth creation with little variation, or faster wealth creation with significant setbacks. But we do not know how to generate fast low volatility wealth creation, even assuming that this was generally considered to be desirable. Moreover there has never been a broad discussion of how much volatility is tolerable. Is an economy that grows at 4% on average over the long run but suffers vicious multi-year recessions occasionally better or worse than one that grows at 3% with much shallower pullbacks?

Investors have proved terrible at addressing these issues not least because they were reluctant to admit to the possibility of setback which was baked into the dynamics of the system.

But why did big shareholders not move to stop over-leveraging before it reached dangerous levels? Why did legislators not demand regulatory intervention? they had no sense of the existing Knightian uncertainty. So they had no sense of the possibility of a huge break in housing prices and no sense of the fundamental inapplicability of the risk management models used in the banks. “Risk” came to mean volatility over some recent past. The volatility of the price as it vibrates around some path was considered but not the uncertainty of the path itself: the risk that it would shift down.

We urgently need to develop a sense not just of the likely near term path of the economy, but also the possible paths - the kind of thing that it might do. If, as I suspect, highly undesirable paths are still somewhat likely, we need to rewrite the rules to make them much less probable.